Jason D. Pride, Glenmede Monthly Insights
The End of the Bond Bull Market
It is easy to understand how these returns could have influenced people’s expectations; however, it is important to step back and look at the bigger picture. Future returns should be the focus and we should not presume a continuation of past performance.
Fixed-income returns have two primary components: yield and price fluctuation. The most predictable of these components is the yield — the longer the holding period, the more dominant it is a driver of returns. If you purchase a bond and hold it until maturity, your return will equal the yield-to-maturity at purchase barring a default. Unfortunately, as of January 31st, 2011, the yield on the 10-year Treasury bond was 3.6%, placing it in the bottom decile of observations over the last 50 years. These yields do not provide a compelling backdrop for prospective fixed-income returns. If we assume interest rates remain unchanged, these low yields will be sub-par to historic performance measurements.
Interest Rate Changes and Returns
While a bond’s long-term return is predictable, near-term returns can fluctuate substantially with interest rate changes. Having experienced a period of falling rates, many investors have become spoiled by the positive outcome of price fluctuations.
Unfortunately, price fluctuations are a double-edged sword. Whereas the past few decades of falling rates have provided a nice boost for bond investors, rising rates will now likely produce the opposite result. In fact,
until recently, many investors did not recognize that even “safe” Treasury securities can actually produce losses if rates rise quickly enough.
Interest Rates, Inflation and Changes in Federal Reserve Policy
A primary determinant of interest rates is the market’s estimate of future inflation. By comparing the difference in coupon yield between Treasury bonds and Treasury Inflation-Protected Securities (TIPS) of the same maturity, we can measure the financial market’s estimate of future inflation.
The market, apparently, is no longer worried about deflation. Instead, inflation is expected to return to more normal levels, which are also roughly in line with what the Federal Reserve considers acceptable.
Of course, inflation is not the entire story. Interest rates can also be influenced as demand for fixed income
products fluctuates due to perceived changes in credit risk, investor demand for protection from volatility and/or Federal Reserve action. The real yield of a fixed-income security is the yield in excess of expected future inflation; essentially, this is the end result of all of these non-inflation related factors.
Real yields are well below the historical median. This should not be surprising, given the Federal Reserve’s renewed quantitative easing program and the market turmoil of the past few years which has driven investors to seek protection. However, it does raise the question of whether this trend has gone too far. First, the Federal Reserve is unlikely to sustain its purchasing spree much longer. Second, investor demand for protection appear to be waning. Lastly, although the credit risk of the U.S. government is normally considered de minimis, mounting debt and continued deficits have driven some to begin questioning our nation’s AAA rating.
The Bond Bull Market: Ending with a Whimper
As a result, it is hard not to foresee a rising rate environment. Interest rates have recently hit multi-decade lows, inflation expectations are beginning to rise and the factors suppressing the real yield on Treasuries are likely to lessen in strength. A reversion to more normal levels of inflation expectations (2.5-3.0%) and real interest rates (also 2.5-3.0%) would result in the 10-year Treasury reaching a yield of 5.0-6.0%.
But, how fast is the rising rate environment likely to occur? In considering the unprecedented sums the Federal Reserve and other central banks have pumped into the system over the past years, many investors fear inflation is around the corner and that the central banks will be unable to contain it in time.
The Federal Reserve has dramatically increased the size of its balance sheet with purchases of mortgagebacked and Treasury securities, yet this has not caused a surge in the flow of money to businesses and consumers.
Lending, while beginning to show some signs of recovery, remains depressed relative to historical levels. The funds created by the Federal Reserve’s balance sheet expansion sit idle on bank balance sheets. Stricter capital standards combined with a lack of borrower demand, as a result of the recession, have caused an unwillingness to lend on the part of these financial institutions.
This leads us to our expectation that the bond bull market will end more with a whimper than a bang. Consumers, having allowed their debts to accumulate to 130% of their disposable income, have a long way to go before they return to fiscally responsible levels. The historical median debt-to-disposable-income ratio is close to 70%, which would require an additional 40%-plus reduction of outstanding debt. Whether consumers repay existing debt or default does not matter; either way, debt reduction acts as an offset to the release of excess reserves. In fact, we believe this was the Federal Reserve’s intention. By significantly increasing the money supply, the Federal Reserve attempted to stem the deflationary effects caused by the deleveraging of American consumers.
Fed Balance Sheet Approaches $2.5 trillion
Furthering the argument against rampant inflation is the current plight of the American labor force. Unemployment remains at an unacceptably high 9% and jobless claims are just starting to return to more normal levels. In light of this overcapacity in the labor force, wages are not expected to rise rapidly in the near future. Inflation, nearly inextricably linked to wage growth, will have a hard time rising quickly as well. While the excess money supply is likely to cause price surges where capacity and supplies are thin, such as agriculture and other commodities, we continue to believe that overall inflation will remain in check. It is for this reason, and the reasons listed previously, that we expect the bond bull market to end more with a whimper than a bang. Rates are unlikely to immediately shoot upward, although there is arguably some risk in this direction.
Investment Strategy
This discussion, in a Winnie-the-Pooh-like obviousness, lays out the prospects for an environment of rising interest rates and diminished bond returns. For many, if their portfolio includes a significant allocation to these fixed-income securities, this outlook may cause uneasiness. However, this is not a situation that has to overwhelm investors. We've included a handful of the obvious and not-so-obvious suggestions for portfolio allocations in this environment below:
1. Underweight overvalued “safe” fixed income: Winnie-the-Pooh himself may have come to this conclusion had he been schooled in the art of fixed-income investing.
2. Emphasize better yield opportunities within fixed income: While all fixed-income securities currently provide yields that are low by historical standards, opportunities remain for relative yield enhancement. Municipal securities continue to provide yields in excess of Treasuries, despite their tax-favored status. However, security selection within this sector is very important given state and municipal budget issues. For tax-exempt accounts, we continue to see opportunities in corporate debt, both investment grade and the highest quality noninvestment grade, as well as in select international sovereign-debt issues.
3. Utilize equities to deliver cash flow: Equities are not as overvalued as fixed income and will likely continue to outperform bonds. Assuming there is flexibility, investors should consider a total-return approach, supplementing income with capital gains realizations as equities rise. Investors that do not have this flexibility, whether due to account distribution definitions or personal preference for income, should consider modifying their equity allocation towards higher dividend stocks. Due to the large range of payout structures within equities, many investors can enhance the yield of their portfolio with little or no impact to the portfolio’s total return potential.
4. Enhance returns and minimize risk with option-based strategies: An additional recommendation that we have mentioned before is to utilize what we refer to as a secured options strategy. In such strategies, the investor sells a call against an equity portfolio, preferably the equity index upon which the option is based. The investor relinquishes some of the more distant appreciation in return for the premium collected each month. Given the current miniscule yields on many fixed-income investments and the reasonably large premiums collected from the option sales, we find this a compelling alternative that can enhance and stabilize portfolio returns.
Kumar Rachapudi, Barclays Capital, Emerging Markets Outlook: Rushing for the Exit?
The escalation of political events in North Africa and The Middle East has opened up the possibility of a further spike in oil prices. Nonetheless, we think EM central banks will be reluctant to tighten monetary policy more aggressively than our current forecasts imply. In rates markets, the 2008 experience suggests the USD120/bbl mark represents a tipping point for higher rates.
What happened
Headlines this week were dominated by political events in Libya, where simmering tensions threatened to boil over into regime change. Risk aversion was the watchword as markets began pricing in the possibility that: 1) global oil supplies could be hit; and 2) public protests could intensify in Bahrain and Algeria. Indeed, some news reports, citing oil traders, said Libya had declared force majeure on oil exports, and foreign companies (the largest producers in the country) were said to be closing production. Meanwhile, protests continued in Bahrain, and Algerian opposition groups were planning organized demonstrations for Friday.
Away from geopolitical events, economic data continued to suggest that the global recovery remains in train. In Asia, Taiwan’s industrial production rose 17.2% y/y. Alongside Korea, Taiwan is at the vanguard of the building global electronics cycle, a factor that will support output in the coming months, in our view. In core Europe, activity indicators continue to point to buoyant activity, despite unresolved issues in the peripheral economies of the region. Indeed, the German IFO and PMI surveys pointed to buoyant order books, another factor supportive of near-term output gains.
What we think
In assessing the impact of higher oil prices on EM economies and asset markets, a useful starting point is addressing whether the recent run-up in prices reflects underlying demand/supply conditions or an increasing geopolitical risk premium. Using global industrial production as a proxy for global demand conditions, it has had a close relationship with the oil price over the past 15 years. The two exceptions are the surge in prices in 2008 and the relatively sharp increase seen so far in 2011. From a supply perspective, Libya represents a relatively small proportion of global oil production, estimated at around 1.8% (or 1.6mn barrels per day). Moreover, current supply conditions in oil markets suggest that larger OPEC members (such as Saudi Arabia) would be able to raise production to offset lower supplies from Libya.
Taking these factors into account, the recent move higher in oil prices can be interpreted as reflecting a higher risk premium. A key question is how central banks will react to a higher and more persistent risk premium that would be implied by a rapid rise in prices from here. In our view, central bank reactions will be framed by: 1) the relative strength of the global economy now versus 2008; and 2) central banks’ reactions to higher oil prices in 2008.
Our estimates suggest that economies in EM were running closer to capacity in 2008 than today. On its own, this points to less dramatic monetary tightening this time round. That’s not to say that the case for tighter policy is absent. Key forward-looking activity indicators for the key developed economy industrial producers (ie, the US and Germany) are much higher than three years ago. As well, similar gauges for emerging economies are stronger (in the cases of Brazil, Korea, Taiwan) or at comparable levels (in the case of China). From a business cycle perspective, then, there is a strong case for policy hikes in EM, ie, that they should follow a less aggressive path than in 2008, a view that is reflected in our monetary policy forecasts.
Another factor that supports this argument is that the experience of 2008 is likely to resonate loudly with the monetary authorities in the coming months. As a result, even if oil prices rise sharply from here, we do not expect central banks to aggressively tighten monetary policy beyond our current expectations. In 2008, increases in policy rates were quickly unwound (for example, in India, Indonesia and Thailand) as the economic impact of weaker demand conditions started to outweigh concerns related to a pick-up in inflation expectations. This factor, together with our view that EM economies have more spare capacity than in 2008, suggests that central banks will be more willing to “look through” a supply-driven spike in headline inflation than in 2008.
What we like
Our central scenario is that there will be a modest increase in risk premiums, but there will not be a marked negative economic impact. In such a scenario, we expect EM central banks that have already tightened to continue their current stance, and we look for higher rates across the curve. However, if oil prices increase more dramatically (and a stagflationary environment ensues), we recommend positioning via curve steepeners, receiving real yields and going long USD against EM currencies. Under this alternative scenario, EM economies would be affected directly via weaker export markets, where consumers would be forced to rein-in spending in response to falling disposable income…..
A sustained increase in oil prices – either demand led or because of an increase in the risk premium – will deteriorate current account balances in most emerging market economies. For instance, in Asia, for every USD10/bbl rise in the price of crude oil, the region’s aggregate trade surplus deteriorates by USD 6.5bn. If oil prices rise to USD120/bbl, Asia’s current trade surplus of USD20bn/month would almost be spent.
In Asia, the clearest losers are India, Korea, Thailand, Taiwan and Singapore. High fiscal and current account deficits combined with high subsidies form the perfect recipe for higher bond yields in India. We think that supply itself will be enough to move 10y bond yields higher towards 8.40% (currently 8.08%) in the next three-to-six months, and the rise will be exacerbated if there is a sustained increase in oil prices. While we currently recommend a 2x5 OIS flattener in India, if oil moves towards USD120/bbl, we think it will be time to position via 5y payers in OIS.
The clear loser in the EMEA region is the Turkish lira. With a current account deficit as high as 6% of GDP, rising oil prices pose significant risk to the currency. Given the TRY’s high pass-through to CPI inflation, we think the local CPI is the most sensitive consumer basket to oil price fluctuations within the entire EM spectrum, which leads us to favour receiving real rates. We also currently hold a 1m USD/TRY strangle, with the view that the new experimental monetary policy will increase implied volatility, which we would look to convert into an outright USD call if oil prices show a sustained move higher.
For most Latin American economies, barring Chile, we think higher oil prices pose a positive demand shock, leading to higher inflation. This is more significant in Brazil, where the COPOM is reluctant to tighten aggressively as higher interest rates will exacerbate currency appreciation pressures.
Siegel + Gale, Global Brand Simplicity Index: 2010
Life is perceived to get easier with age in the US and Europe—in China and India this doesn’t hold true
Despite the economic worries many have in the West, it seems one worries less about life as one gets older in the US and Europe, while in China and India, retirement age brings new complexities. This might signal that dealing with an increasing elderly population in these countries is more challenging than in the Western countries.
Fast-food hasn’t lost its appeal
Despite everything you might read in food magazines about the “slow food” movement, people globally continue to value the benefit of being able to quickly pick up prepared food. Brands like McDonald’s, Burger King, KFC, Pizza Hut, Starbucks and Subway not only make it easy for people to get food, but also communicate clearly what they offer: they are focused, don’t overwhelm you with choices and give you the sense that they are a good value within their particular niche. Locally customized menus also help.
Technology is perceived by most as simple
As an industry, technology ranks in the top three in terms of simplicity of communications and interaction. The focus on ease of use and the life-changing effect many devices have had (especially mobile phones) probably contributes to the technology industry’s high marks.
People are willing to spend more on simplicity, but not always where it’s needed most
A significant proportion of people are willing to pay more for the benefit of simpler products and interactions. However, many more (about twice as many) are willing to spend more on technology and telecom than on insurance and mortgage banking for greater simplicity. Open ends show that people are willing to pay more for complete coverage and that the biggest issue with health insurance is not the premium, but the unforeseen exclusions and personal liabilities once you have a health issue.
Many local brands get high marks for simple communications and interactions
When you look at the top Simplicity Index brands in most countries, they are not known in outside markets. However, they are doing things right in terms of simplicity. Which begs the question: how local is the concept of simplicity? We know that the word does not always have positive connotations in China and India (which is why we used “less complex” rather than “simpler” in our survey scales in these countries). But obviously local knowledge and familiarity also play a role in delivering simple brand experiences.
Designers and people in the Middle East love Apple…but many others don’t
Apple ranked lower in simplicity than other tech companies, including Samsung, Canon and even HP and Dell in the US. Why? Two reasons: non-users find the operating system intimidating, and iPhone users gripe about service problems and a revolving blame game between Apple and AT&T.
Simplicity and value are linked in multiple ways
Our research shows that there is money to be made in simplifying products, interactions and communications. Offering deals and helping people save money is also associated with people’s perceptions of simplicity. Globally, people seem to be saying, “If you help me save money, you’re making my life easier. And if I think you are overcharging me, I won’t trust you.” By communicating clearly and transparently, trust and perceived value will increase.
The takeaway: Clarity and transparency pay. Brands that communicate simply and provide outstanding customer experiences can differentiate on this basis, charge a premium and gain customer loyalty in the process.
Americans are notable for their midlife crises and the simplicity drop-off in the uppermost income bracket. While the restaurant and retail industries are winning customer loyalty by easing the burden of choice and enhancing their customer experiences, the credit card, insurance and banking industries are leaving money on the table—in the case of insurance, $6 billion a year.
DVD and online video rental company Netflix won the top spot in the rankings— a result to be expected from the leader of the company as Fortune magazine’s 2010 “Businessperson of the Year.” Netflix has effectively redefined the movie rental category, and is reshaping how people consume made-for-TV entertainment. Customers were charmed by its elegant, easy-to-understand interface, “all you can eat” pricing scheme and boundless selection.
Specialty grocer Trader Joe’s also scored well, with customers appreciating its unique model: smaller locations carrying fewer items of higher perceived value and at a greater discount than at ordinary grocery stores. While typical grocery stores carry around 50,000 SKUs, Trader Joe’s stores average about 4,000— with 80% of the stock bearing the Trader Joe’s house brand. Exploiting the fact that consumers prefer value to selection, the business is an excellent example of reduced choice equating to greater simplicity.
Finally, contrary to conventional belief, the United States Postal Service is seen as simpler than some of its rivals, slightly outpacing private carriers FedEx and DHL. This finding matches internal USPS data, showing a steady improvement in customer service
Damien Conover, Morningstar Healthcare Observer
Big Pharma needs to propel long-term growth in the face massive patent losses and relatively poor R&D productivity, and we expect firms will redeploy their strong cash flows for biotech acquisitions (see biotech takeout list for top-ranked targets on page 6). Also, we expect further consolidation in Big Pharma and project that prices of Eli Lilly LLY (FV: $42) and Bristol- Myers Squibb BMY (FV: $28) will begin to incorporate a takeover premium as the patents on their lead drugs expire in the 2012-2013 time period. Additionally, we expect diversified Big Pharma companies will pay a strong premium for the healthcare segment of Church and Dwight and Prestige Brands PBH (not rated) in an effort to continue to diversify operations.
Big Pharma Should Continue to Use Deep Pockets for Acquisitions to Fuel Long-Term Growth
Investment Takeaway
Big Pharma needs to propel long-term growth in the face massive patent losses and relatively poor R&D productivity, and we expect firms will redeploy their strong cash flows for biotech acquisitions. Also, we expect further consolidation in Big Pharma and project that prices of Eli Lilly LLY (FV: $42) and Bristol- Myers Squibb BMY (FV: $28) will begin to incorporate a takeover premium as the patents on their lead drugs expire in the 2012-2013 time period. Additionally, we expect diversified Big Pharma companies will pay a strong premium for the healthcare segment of Church and Dwight and Prestige Brands PBH (not rated) in an effort to continue to diversify operations.
With pharmaceutical companies either approaching or already suffering through their patent cliffs, we expect several firms will bolster their growth prospects through acquisitions. Supported by solid balance sheets and strong cash flows, we expect Big Pharma firms to scoop up several biotech companies as well as a few diversified healthcare companies. Over the long run, we expect continued consolidation within the large-cap ranks. However, due to anti-trust concerns, the next wave of consolidation may be delayed until certain drugs lose patent protection.
Big Pharma Needs to Buy Growth
Excluding Abbott ABT (FV: $68) and Novartis NVS (FV: $71), the growth prospects for most Big Pharma firms are weighed down by significant patent losses (see chart below). Following the patents cliffs, we project most Big Pharma firms will face a prolonged period of single-digit top-line growth. Despite the slow growth, we expect cash to accumulate quickly given the industry’s high return on capital. Therefore, while we project continued increases in dividend payouts and share repurchases, and we expect Big Pharma firms to redeploy cash to increase their long-term growth prospects through acquisitions.
Financial Strength of Big Pharma: Who Has Capacity to Buy
All of the large pharmaceutical companies hold strong balance sheets and generate robust cash flows. Recent major mergers and acquisitions have added heavy levels of debt to Merck (Schering- Plough), Pfizer (Wyeth), and Novartis (Alcon). Also, GlaxoSmithKline GSK (FV: $47) carries a high level of debt. The remaining companies are all in good positions to make acquisitions. Even the debt-heavy companies could still make smaller tuck-in acquisitions. Further, we expect the debt markets will remain open for the Big Pharma companies, charging interest rates in the low to mid-single digits, which makes many acquisitions largely accretive very quickly.
Patent Losses Drive Further Diversified Healthcare Purchases
While biotech and specialty pharmaceutical acquisitions by Big Pharma will likely be the focus over the next several years (see article on page 6), we believe the increased volatility surrounding patent expirations is pushing more diversification into more stable over-the-counter healthcare goods. Consumer products offer a pathway into emerging markets; These products tend to carry strong brand power, a key factor in emerging markets. The acquisitions of Chattem by Sanofi-Aventis SNY (FV: $44) and Stiefel Laboratories by Glaxo show the increased interest by Big Pharma in diversifying away from the pure-play drug companies.
We believe the most likely consumer healthcare targets are Prestige Brands and Church & Dwight (healthcare products segment), which both sell several market-leading consumer healthcare products. We think Johnson & Johnson JNJ (FV: $75), GlaxoSmithKline, Novartis, Sanofi or Pfizer PFE (FV: $26) would be willing to pay a premium to acquire either of these companies, as all of these Big Pharma firms are seeking to increase the diversification of their revenues.
Major Big Pharma Consolidation
The beginning of the last decade brought a massive wave of consolidation within the pharmaceutical industry with the acquisitions of Warner Lambert, Pharmacia, and Aventis as well as several mergers. These mega acquisitions largely left the acquiring company in no better shape than before the merger, which has led most of the investment community to question the value of massive mergers, in particular the recent Pfizer/Wyeth and Merck/Schering mergers. While we agree that the mergers which took place ten years ago didn’t appear to add much value, we would argue that recent large acquisitions should drive value for the acquiring companies.
The price paid for the targets and the expected cost synergies should result in better outcomes this time around for the acquiring companies. In both the Wyeth and Schering acquisitions, the companies were purchased at approximately 14 times trailing 12-month earnings, as compared to an average of close to 40 times earnings for major acquisitions that took place earlier in the decade. Additionally, the expected cost synergies of the recent acquisitions averages 8% of the purchase price versus 3% for the previous wave of consolidation. Based on the lower purchase prices and the higher expected amount of cost synergies, we believe the recent acquisitions will add value to acquiring companies.
The expected success of recent acquisitions suggests that Bristol-Myers and Eli Lilly could be acquired. While both Bristol and Lilly face major patent expirations over the next few years, an expected low purchase price and anticipated cost-saving synergies could entice a major pharmaceutical company to acquire either of the companies. At a 35% premium to current stock prices, the implied price-to-earnings ratio for Bristol and Lilly would be 17x and 11x, respectively. Further, we estimate that over $2 billion in cost savings could be achieved, which would equal close to 4% of the purchase price for both deals. While the mergers seem to make sense, due to anti-trust regulations, we expect only a few companies could acquire Bristol or Lilly. In Bristol’s case, we believe Sanofi, Abbott or Glaxo could make the acquisition without divesting major drugs to appease the anti-trust regulators. In Lilly’s case, we believe Abbott could potentially acquire the company with only minor product divestures. Further, following the major patent losses for both Bristol and Lilly by 2013, many more acquirers could target the companies without anti-trust concerns. As the companies approach their patent cliffs, we expect the companies’ stock prices to incorporate takeover premiums.
Big Pharma Poised to Acquire in the Fragmented and Fast-Growing Emerging Markets
With emerging markets offering strong growth potential but hurdles for direct build out, we expect several more acquisitions in emerging markets to further entrench Big Pharma’s product lines. With household incomes in the BRIC (Brazil, Russia, India and China) population expected to increase 16% annually for the next five years and drug spending correlated 80% to income growth2, we believe Big Pharma firms will want to increase their exposure to these fast-growing geographies. Further, companies can avoid a high tax payment by using overseas cash (taxed at a lower corporate rate) to make emerging market acquisitions rather than repatriate cash back to the U.S. and pay a high tax rate for a domestic acquisition. Additionally, the high degree of fragmentation in emerging markets opens the door for many small-scale acquisitions. For example, in China, no single company represents over 2% of the total drug market. We believe all the local Chinese companies represent likely takeover targets as long as not too much power leaves China’s protective government.
